During the tumultuous economic period caused by the coronavirus pandemic, there are a myriad of indicators of public market performance. The Dow Jones Industrial Average1 had its largest single day drop in history, and the Federal Reserve has cut interest rates to 0%. But it can be harder to determine the effects on markets that are not reflected in the stock market.
While commercial real estate has historically been a slower reacting market, if COVID-19 continues to have an impact on the broader economy, it will eventually show in real estate markets. Formerly reliable tenants may suddenly not be able to afford rent. Quarantines and social distancing will create slower revenue and growth in commercial real estate and may cause defaults on commercial loans. New construction projects may be delayed due to supply chain disruptions and labor shortages. Some places, such as major cities in California, have put moratoriums on commercial evictions, which may prevent property managers from being able to collect money or re-lease space, and may create an inability for owners to pay their mortgages or provide dividends to their investors.
According to Cohen & Steers, a real assets investment management firm, hotels, hospitality, senior housing, retail, and offices will be most affected. Meanwhile, single and multi-family housing, cell towers and data centers, industrial, self-storage, and medical will likely be less affected.
However, government stimulus and potential regulation may come into play to ease the economic impact, and create unique opportunities for sponsors, advisors, and investors in the market. We’ve looked at three specific real estate investment types—1031 Exchanges, Qualified Opportunity Zone Funds, and Non-Traded REITs—and how market participants can react to this new economic environment.
1031 EXCHANGE DSTs
In a 1031 exchange, taxpayers must identify the replacement property within 45 days of the initial sale and close on the replacement property no later than 180 days from the initial sale. The current crisis poses a risk to investors who may have trouble identifying a new property as a result of the economic turmoil. However, these deadlines could be extended if the IRS were to designate a “federally declared disaster.” During a national or localized disaster, the IRS can identify the location(s) affected by a disaster and the duration of the disaster period. In the recent past, the IRS has declared disasters for hurricanes, wildfires, earthquakes, and other localized natural disasters. A list of recent disasters can be found on the IRS website. For something like the COVID-19 pandemic, it is likely that the disaster zone would encompass the entire United States.
If an extension were granted, the IRS guidance allows for an extension of up to 120 days past the final day of a declared disaster. However, extensions can be cut short and may not stretch beyond the tax-payer’s tax-return due date for the year in which the exchange took place or 365 days from the sale of the original property. Property’s sold within the duration of a disaster are ineligible for an extension.
It should also be noted that the extensions do not apply to properties sold within the duration of a federally declared disaster. So once a disaster is declared, there may be a reduction in the number of properties that are put up for sale as investors wait out the pandemic.
The National Association of Realtors has already submitted letters to the IRS requesting extension of these deadlines, as well as other stimulus for investors, landlords, and businesses affected by the pandemic.
Delaware Statutory Trust sponsors may be facing their own issues with cash flow as a result of the pandemic as tenants of their properties may have trouble paying rent or they struggle to fill vacant space. Some 1031 exchange DST sponsors may cut their distributions to keep cash reserves up. While this may make their product less attractive in the short term, it allows the trusts to keep operating through the crisis. DST offerings that are debt free may be in a better position as they do not have any debt service obligation and instead can continue to pay their investors from cash flow.
QUALIFIED OPPORTUNITY ZONE FUNDS
Much like with 1031 exchanges, Opportunity Zones have provisions that allow for extensions of deadlines due to federally declared disasters.
One such deadline is the 31-month Working Capital Safe Harbor. The Working Capital Safe Harbor (or WCSH) allows businesses within an Opportunity Zone a 31-month period to attract investor capital without being disqualified as an “opportunity zone business” because of their large cash reserves, so long as they have a written plan to deploy that capital for uses such as business development or the acquisition or improvement of assets. This is designed to help businesses get up and running while still taking advantage of the tax benefits afforded to opportunity zone businesses. US Treasury regulations automatically extend the WCSH by an additional 24 months if an opportunity zone business is located within a federally declared disaster area.
Additionally, with many government employees designated as non-essential and told to stay home, sponsors may experience delays in their projects as a result of waiting for government approval on applications for things like building permits or zoning changes. Any such delays that bring the project to a full stop can be deducted from the 31 months, extending the time of the safe harbor. If the delay only effects parts of the project, but others are able to proceed, then the delays are ineligible to be deducted.
While opportunity zone businesses (QOZBs) have to worry about their own qualifying status, qualified opportunity zone funds (QOFs) should also be concerned. In order to qualify as an opportunity zone fund, 90% of the assets held by the fund must be property within an opportunity zone or be equity in businesses that qualify as QOZBs. If businesses fall out of that status, or fail all together, as a result of delays caused by COVID-19, a fund’s assets may fall under the 90% threshold, eliminating their tax-advantaged status.
On the investor side of things, the same 180 day period that applies to 1031 exchanges exists for rolling over capital gains into a QOF. One advantage opportunity zone funds have over 1031 exchanges in the midst of this crisis, is that assets do not have to be like-kind in order to roll-over into a QOF. Investors who pulled out of the stock market in anticipation of a recession now have capital gains that are eligible to be rolled over into opportunity zone funds.
According to Green Street Advisors, public REITs, which usually perform relatively well during stock market declines, have been hit hard by recent volatility. Even, non-traded REITs, which are often priced based on the value of their underlying assets rather than by the market, are starting to decrease their NAVs and some sponsors are cutting distributions.
Non-traded REITs are coming off of a year of record growth. Mack Burke of the Commercial Observer writes, “this year began where REITs had the highest capital and the lowest leverage that they’ve had in 20 to 25 years...They’ve started the year with occupancy rates at or near record highs.” These factors put non-traded REITs in a good position to weather the economic storm.
However, even with a solid foundation, many REITs may experience a reduction in cash flow due to reduced rent payments. Sponsors that find themselves in a difficult position do have some options to free up some cash. REITs are required to distribute at least 90% of their income to investors in the form of dividends. While many distribute closer to 100% of their income, one way to weather the current crisis would be to shore up cash reserves by distributing only the minimum amount. Any amount under 100% that is not distributed would be subject to corporate income tax. REITs are also able to defer dividends until the end of the year, freeing up cash in the near-term in hopes that normal cashflow returns by the end of the year. Sponsors who take either of these paths risk upsetting investors who are anticipating the regular distributions they have become used to.
As the pandemic continues to play out, market participants should keep in mind the risks of real estate investments, including illiquidity, vacancies, general economic conditions, competition, potential adverse tax consequences, and the potential loss of invested capital. While the stock market is down, alternatives such as real estate may look attractive due to low correlation and diversification potential.2
1 - The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.
2 - Diversification does not guarantee profits or protect against losses.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Disclaimer: WealthForge provides this information for educational purposes only. It should not be construed or relied upon as legal or tax advice.